http://www.jewishworldreview.com --
THE turmoil in foreign exchange markets spreading from the Southern Cone
of South America to Eastern Europe and Southeast Asia exposes the growing
risks to global capital markets arising from the Fed's continued inability to
overcome a deflationary scarcity of dollar liquidity.

As monetary authorities from Brasilia to Warsaw and Singapore -- and many
points in between -- wage a largely futile battle to keep their currencies
from sinking to new lows against an ever-appreciating dollar, the Fed's
culpability is almost entirely overlooked. In echoes of the crises of
1997-98, one again hears of "contagion" infecting emerging market currencies,
as if an exotic strain of financial virus has been released into the markets
at random. Like that earlier episode, however, the common thread running
through the turbulence now affecting the emerging markets is the Fed's
squeeze on dollar availability.

This is seen first in deflation of the prices many commodity producers rely
on to service their dollar-denominated debt. The problem is compounded as
dollar debtors, seeking to hedge their exposure in increasingly risk-averse
conditions, sell short their local currencies against the dollar. This
defensive action drives the dollar higher still as the Fed fails to satisfy
the overseas dollar demand.

It is some consolation that two separate pieces in Sunday's New York Times,
including the front-page lead, called attention to the high-flying greenback
as a factor that could hinder U.S. economic and equity market recovery,
particularly due to its impact on export volumes and exporter profits. As to
how the currency could be continuing to reach new 15-year highs, even in the
face of 275 basis points in Fed rate cuts, the reports could only offer that
the dollar remains a "safe haven" in uncertain times.

That tells only half the story, though, as the dollar is in fact a "safe
haven" from the strains being created in the first place by the currency's
excess scarcity. The global dollar shortage is surfacing in the Fed's
liquidation of custody holdings for foreign central banks. As the central
banks are forced to cash in their dollar-denominated assets to satisfy demand
for scarce greenbacks against their home currencies, the Fed's portfolio of
official dollar holdings has contracted on net by more that $20 billion since
mid-March. In retrospect, similar forced liquidations of dollar reserves
ended up as telling precursors of sharp downdrafts in the deflation-induced
financial panics of '97 and '98.

Whether or not another such financial firestorm lies in store, the Fed's
open-market operations give rise to serious doubts as to whether its current
stance can be considered an "easing" of liquidity conditions in any real
sense -- as a more abundant supply of dollars relative to demand. Overall,
the Fed's balance sheet assets have been growing year-over-year at a rate of
about 5%. That's an improvement on the negative growth rates earlier in the
year, when year-to-year comparisons were still dominated by the Fed's Y2K
liquidity bulge. But the recent trend is still down from the balance sheet
expansion of more than 7% a year ago, in the aftermath of the Fed's final
rate hike in its 175-basis point tightening cycle.

Certainly, sensitive market indicators of the Fed's liquidity posture show
little evidence of more ample supply relative to demand. In fact, at around
$266 per ounce, gold has retreated by some $10/oz. from its levels just prior
to the June 27 FOMC meeting, and is now back below levels seen at the
initiation of the Fed's rate-cutting exercise in early January. A steady
decline in broad commodity indexes confirms gold's deflationary signal.

What's the solution? The Fed and Treasury should work together to stabilize
the dollar's exchange rate index around current levels. For its part, the
Treasury should publicly announce its support for a stable -- but not
stronger -- dollar index. At around 120, by the way, the trade-weighted G-7
dollar index is up about 10% so far this year.

Then the Fed should back up this policy with a faster rate of dollar
creation. This would mean an 8% - 10% expansion rate for Federal Reserve
credit (or the monetary base), the central bank's basic liquidity measure.
Given the current weakness in private credit demand, a step-up in base growth
would be consistent with a funds rate settling around 3% to 31/4%, down from
today's liquidity-restraining rate of 3
3/4%.